Volatility Measures Support The Bullish Case

Headlines in March were volatile, but the U.S. equity market did not reflect this volatility. European sovereign debt issues again came to the forefront, and such headlines during the past few years have, at least temporarily, seen calm waters transform into rough waters. As of now, however, S&P 500 Index historical volatility has dipped back into single digits — a rare feat, and certainly surprising to many market participants (more on this later).

As you can see on the chart below, historical volatility is firmly planted in single-digit territory as we move into the second quarter of 2013, even as we’re constantly getting hit over the head with negative developing headlines overseas — whether it’s Italian elections, the bailout of Cyprus, or fears that Cyprus may become a “template” for other euro-zone countries on the brink of default.

The bull has been tested on several fronts, but so far has not bent. For example:

-Negative European headlines usually translate into increasing volatility and declining stock prices, but so far equities have been resilient amid declining volatility. -In the context of the overseas fiasco, the charts have given market participants every excuse to sell, with the SPX “overbought” by definition, and trading near major peaks from 2000 and 2007. -There was evidence, both in the National Association of Active Investment Managers (NAAIM) survey and in our own analysis of option activity, that hedge funds and institutions were decreasing their exposure to equities during the past few weeks. With the market not imploding as some feared, we are seeing evidence on both fronts that this group’s appetite for stocks has increased in recent days, which is supportive. -The market has stood firm, even as headwinds from the “urge” to protect portfolios via CBOE Market Volatility Index (VIX) call buying hit a record level during March. In fact, VIX call open interest is well on its way to another record, with over 6 million VIX call contracts outstanding early in the expiration cycle. These recent call buyers must be surprised by the lack of volatility amid a flurry of news that could certainly have been expected to drive volatility higher and equities lower.

Finally, a look at the current sentiment backdrop compared to late-January/early February — when the S&P 500 challenged the 1,500 level before moving sideways, and then pulled back to its 40-day moving average before finally shooting higher — suggests the availability of more buying power at present. For example:

Short interest on S&P 500 component stocks has increased 5% since early February, and these “fresh shorts” are likely in the red and feeling pressure to cover.

The NAAIM survey average was 104.4 on Jan. 30, compared to 80.06 at present. The higher the number, the higher their exposure, and the Jan. 30 reading suggested slightly leveraged long exposure before this group reduced their exposure.

The American Association of Individual Investors (AAII) weekly survey pegged the bullish percentage at 48% in late January, higher than the current level of 38%.

It appears the “half-century” marks on the Russell 2000 Index (or IWM ETF) and S&P MidCap 400 Index (or MDY ETF) are still in play as short-term speed bumps. Additionally, the S&P 500 at 1,568.80 represents a 10% year-to-date gain for the index, and we’ve noticed that round-number year-to-date returns can sometimes trigger profit taking. (You can track the S&P 500 Index with the SPY ETF.)

But as we also observed last week, the larger speed bumps on the RUT and MID are the 1,000 and 1,200 levels, respectively. It took the MID almost two years to clear the 1,000 level after its first attempt to break though in April 2011, and 1,200 on the MID represents triple its 2009 low.

Bulls should not disturb their long positions unless the VIX is trading higher than 17.00, which is 50% above its calendar-year low, and the SPY is trading below its 40-day moving average, which is currently situated at 1,531.22. The new record closing high on the SPX on Thursday could pressure more shorts to cover, but bears may need some convincing that a major triple top is not in the works, and may instead be focused on the index’s all-time intraday high of 1,576.09. Therefore, more sideways movement could be in store until earnings season begins.

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